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By New_Deal_democrat July 9, 2015 11:49 am
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Corporate profits as a leading indictor for quarterly stock averages: midyear 2015 update
This is an update as to a relationship I have written about several times in the past year.
See, e.g., http://community.xe.com/blog/xe-market-analysis/corporate-profits-leadin...
The relationship is straightforward:  if corporate profits are a long leading indicator for the economy, and stock prices are a short leading indicator, then logically corporate profits should lead stock prices at least in terms of direction, if not necessarily in terms of volatility.  Since we now have 1st quarter corporate profits and 2nd quarter average stock prices, let's update this data.
Let's look at this two ways: YoY and in absolute terms.  First, here is the YoY% change in corporate profits (red) vs. the YoY% change in the S&P 500 averaged over each quarter (blue):

We can see that generally stocks do follow corporate profits, but with a very variable lag.  Corporate profits  have only gained about 5%+ YoY for three years, but stocks climbed as much as 20% YoY.

Of course, this really just tells us that the price to earnings ratio for stocks has increased.  That doesn't necessarily tell us that stocks are risky or overvalued.  So let's look at corporate profits and stock prices in absolute terms.  The following graph norms corporate profits (blue), as well as stock prices (red), to 100 as of 10 years ago:

Since the beginning of 2012, corporate profits have only risen a little over 10%, while the S&P index has shot up by more than 50%.

The above graph confirms that corporate profits did lead stock prices at both their respective tops prior to the Great Recession, and their respective bottoms during that recession.  It also gives us some perspective on relative valuations - as a percentage of deflated corporate earnings, stocks are roughly in the same status as they were in late 2006 and in 2007, as shown in this graph which divides stock prices by corporate profits, normed to 1 in Q1 2005:
 While this is equivalent to their pre-Great Recession highs, keep in mind that while a P/E ratio of 20 was once considered an upper extreme, stocks stayed at P/E's over 20 for most of the period 

None of this suggests that stocks are in any imminent danger of a crash or a bear market.  While stocks may be relatively highly valued compared with corporate profits, which themselves are historically high, the fact remains that as of the 1st quarter of 2014, corporate profits were still growing.

Usual disclaimer:  I am an economic blogger. I do not pretend to be a securities analyst.This post contains  my opinions and observations. It is not professional advice in any way, shape or form and should not be construed that way. In other words, buyer beware.
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